Tuesday, September 20, 2016
I find the cycles in technology fascinating, and it's an unfolding lesson of historical cycles. Although we believe our industry moves at a rapid pace there are many macro cycles which occur over decades, the patterns do not change much. The first and current example is HP Software (with more focus on IT Operations). Let's rewind to the foundational pieces of HP Software, which came from the acquisition of Mercury Interactive in 2006. HP spent $4.5b to purchase Mercury and built a large well-established business off the platform in both Quality Assurance (QA) and IT Operations. Over time HP failed to invest, in what at one point was the market dominance of QA and a substantial footprint in ITOps, these once large market shares eroded as technologies commoditized and the buying shifted to best-of-breed. HPs solution set became difficult to implement (even for HP engineers), and ongoing management is hard requiring consulting and many resources. Having managed this portfolio at scale in the past, I felt this pain first hand. I speak to customers regularly today who use these tools, and none of them are satisfied users. The inability for these technologies to meet buyer demands and the burden of maintaining them resulted in significant market share decline. Based on the Gartner market share data (Market Share: All Software Markets, Worldwide, 2015) HP software's revenues from 2013 to 2015 went from $4.4b to $3.4b showing a major issue in execution.
This kind of decline is highly abnormal within healthy businesses, and may be overstated by the Gartner data, but it creates an opportunity for companies who have inexpensive access to capital. Due to the low-interest rates, and the need for debt investments, there is ample access to cash. Just yesterday Thoma Bravo raised another $8b fund, which was oversubscribed. Capital supply is outstripping the amount of companies available to be acquired and streamlined. The criteria for these acquisitions focus on taking advantage of the massive amount of software maintenance generated by enterprise software businesses. There are examples of companies who's business goal is collecting software maintenance and lack innovation.
Analyzing HP's earnings statement filed on September 9th the software margins were only 17% (http://investors.hpe.com/~/media/Files/H/HP-Enterprise-IR/documents/q3-2016-quarterly-results.pdf page 11) meaning the optimization would improve profit. Most of this profit comes from maintenance versus new product sales or innovation.
Micro Focus is a good fit for this kind of business. Micro Focus has acquired loads of once innovative assets that have large install bases collecting maintenance revenue. Micro Focus' business includes software assets resulting from the merger of Attachmate, along with new additions. Much of the product set is a plethora of Mainframe software but also includes SUSE Linux, NetIQ, and other software graveyards. I still see quite a bit of NetIQ out there, but it's large legacy install bases especially in the Government Vertical. Replacement of these legacy management tools is a challenge; the result is a long tail of software maintenance. These customers pay vast sums of money for maintenance while getting no technology advances.
Analyzing the Micro Focuses annual report, maintenance outpaces license sales by over 2x. License sales and maintenance both declined between 2015 and 2016 with maintenance suffering a larger decline. That decline is a result of customers switching providers or technologies, and stopping maintenance payments.
Other notable examples of privatization and PE was the acquisition of business model innovator Solarwinds. Solarwinds IPOed in 2009 with $116m in annual revenue and had grown the business to $428m of annual revenue before being privatized in 2016. Solarwinds created not only simple and cost-effective tools for engineers but did so by only leveraging inside sales, driven by aggressive email marketing. Solarwinds figured out this formula long before companies like Marketo (and others) made is easy to build similar models. For many years, SolarWinds had a business advantage in the selling and marketing of its offerings to the technologist buyer. The tools weren't much better, but they were cheaper, easier to try and buy, and the value was there. Solarwinds ran into issues when others were able to replicate the business model they had, removing some of its advantages. As a response Solarwinds had to expand its portfolio, often too quickly to meet the demands of Wall Street investors. Several of SolarWinds acquisitions were not well thought through, and the efficiency of the business suffered. The net margin was over 30% in 2011, and when they were privatized in 2016, it was down to 18%. The SolarWinds portfolio today consists of many products which are not tied together, and highly complex to adopt. They still have several good technologies, but using them together provides no advantages. The current situation leaves a lot of room for current PE owners Silver Lake Partners and Thoma Bravo to optimize the spend and business, which will result in profits for their fund investors. Unfortunately, it will likely not result in a lot of investment in the technologies to keep place with the current market demands.
Similarly, Dynatrace was a highly innovative product at the time of the first public product in 2006 they focused on a gap in the market with an offering to address performance during the development and testing lifecycle. After expanding from Europe to the US, it was acquired by Compuware in 2011 for $256m and became part of a portfolio of products. After Compuware was acquired by PE in 2014, they split apart the mainframe business of Compuware (and kept the name) and brought back the Dynatrace name to handle the Application Performance Monitoring products. In the meantime, the PE firm also took Keynote private and combined them into Dynatrace. Over 14 years of being public Compuware's revenues went from a peak of $2.23b in 2000 to a low of $720m in 2014, which is less revenue than they made in 1997. Today the Dynatrace portfolio consists of several products which have different backends, user interface, and technologies. You are probably noticing a trend here, and it doesn't benefit the end users of these technologies.
A slightly older acquisition by PE, the privatization of BMC occurred in 2013. With the help of BMC's new owners, the optimization has taken hold; they are focusing on specific assets. The reduced spending has slowed revenue decline. From 2013 to 2015 based on the Gartner data BMC's revenue dropped from $1.87b to $1.84b. BMC's privatization required raising a massive amount of debt, affecting the risk rating of the company's ability to repay those debts. Based on Moodys over $6.7b in debt was raised (https://www.moodys.com/research/Moodys-downgrades-BMC-to-B3-rates-new-parent-notes-Caa2--PR_296668) causing an increase in investor risk. Similarly, when you look at the LinkedIn company data regarding BMC, the employee count has been reduced by 7% in the last two years, while the investment in engineering and sales headcount increased 1%. PE firms are cutting staff, and optimizing the business.
Dell/EMC is yet another example of two companies which have been taken private. Similar stories playing out at other large corporations including IBM, and CA. Each has similar stories, and the final shoe has not dropped yet around their software businesses. IBM has some successes in software, but the IT Operations software business is in a similarly dire situation to what has been seen above. In my past predictions, I expect CA to be taken private before the end of next year (2017), we'll see how accurate that turns out to be. Although Mike Gregoire has made some drastic improvements since taking the helm in late 2012, yet CA's portfolio continues to be legacy (heavy on the Mainframe) with almost no revenue coming from SaaS subscriptions.
In recently published research by Gartner's Gary Spivak (I&O Leaders Must Actively Respond When Key Vendors Face Activist Investor PressuresPublished: 29 March 2016 ID: G00291934) he states in his strategic planning assumption: "By 2020, eight of the top 12 publicly traded IT operations management (ITOM) vendors will respond to pressure from activist investors to sell all or parts of their businesses." As someone who studies the financial and market side, I'm quite happy to be siding with Gary's perspective on the future of this market.
You can probably spot the cycles I have highlighted, I would expect these to continue happening, especially if borrowing money remains cheap, and accessible capital remains high.
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